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The Complete Couch Potato Roadmap

ETFs can help you build a low-cost portfolio, but how do you know which to choose?

Just over a year ago, I became a convert to MoneySense’s Couch Potato strategy. By investing in low-cost funds designed not to beat the market, but to match it, I’m confident I will enjoy better returns. After all, more than 92% of Canadian equity mutual funds have lagged the market over the past five years, largely because Canada has some of the highest fund fees in the world. I feel safer too, knowing that my investments are diversified across thousands of stocks and bonds.

This proven strategy (sometimes called “index investing”) has exploded in popularity over the last decade thanks to the arrival of exchange-traded funds, or ETFs. These funds are similar to mutual funds in that they are pooled investments that hold a number of stocks or bonds. However, unlike mutual funds, ETFs trade on a stock exchange, so you can buy and sell them throughout the day. And rather than being run by a high-priced manager who tries to beat the market by picking winning stocks, most ETFs deliver returns similar to the overall market by buying virtually every stock in an index. As one proponent of the strategy puts it, instead of looking for the needle, you’re buying the haystack.

I’m pleased with my new portfolio, but I have to admit that building it wasn’t as easy as I expected. Until about three years ago, choosing ETFs was dead simple, because one company— iShares—had the Canadian market largely to itself. Today, there are three additional ETF sponsors in Canada—Claymore Investments, BMO Financial Group and Horizons—and the four companies together offer more than 100 different funds. There are also more than 800 other ETFs available on American exchanges. The variety is welcome, but it makes things more confusing for investors, including me. At least half a dozen times, I bought an ETF that looked good, only to sell it weeks later when I discovered one that followed a better index, was more broadly diversified, or had a lower fee. As a result, I blew a few hundred bucks on trading commissions. But just because I wasted my time and money, that doesn’t mean you have to.

I’d like to walk you through the important questions you need to ask when choosing the right ETFs for your investment goals. You’ll learn how each fund chooses the stocks or bonds it holds, and why you should consider fees, diversification and the effect of foreign currency exchange. Some of this information is complicated, but we’ve organized it into easy-to-follow sections, so you can get all the detail you want, or simply skip ahead to our model ETF portfolios (see “Ready to build your own portfolio?”), where I’ve done the heavy lifting for you. Ready to go? Then let’s begin with the first question.

Which index do you want to follow?

Indexes have been around since Charles Dow created the famous Dow Jones Industrial Average in 1896. Simply put, an index is a group of stocks or bonds used to measure the performance of a particular market. For instance, the Dow includes just 30 large American companies from various sectors, but it is considered a barometer of the entire U.S. stock market. The S&P 500 and the Russell 1000—which include 500 and 1,000 stocks, respectively—are much broader indexes of large American companies. The S&P/TSX Composite Index, which includes about 200 companies, is the most popular benchmark for Canadian stocks. Other indexes measure the fixed-income market, such as the widely used DEX Universe Bond Index, which covers both government and corporate bonds.

An ETF attempts to deliver the same return as its underlying index, and it does this in a straightforward way: by owning all (or almost all) of the stocks or bonds in that index. Whereas a mutual fund manager might pick the 15 or 20 Canadian stocks he thinks will outperform the S&P/TSX Composite, an ETF would simply buy all 200.

This was easy to understand when there were just a few ETFs and they all used well-known indexes. But today there are thousands of indexes tracking every region, asset class, market segment and investment style. You can find indexes and ETFs that track Vietnamese stocks, the wind power sector, the Indian rupee, and the price of corn.

It’s easy to learn which index an ETF tracks: just visit the sponsor’s website (see “The ETF marketplace”) and find the section devoted to that fund. The index is always listed prominently, usually with a full explanation of what it includes. The more difficult question is whether the index is of any value to investors.

“People can use common sense for the most part. If it sounds weird and wacky, it probably is,” says Mark Yamada, president of PUR Investing, a Toronto firm that builds custom ETF portfolios for its clients. One recently deceased ETF included only Wal-Mart suppliers. “There was another one for suppliers to the Beijing Olympics. Somebody must have thought these were good ideas.”

Couch Potato investors looking to build a basic portfolio should steer away from niche products and stick to indexes that follow the major asset classes, such as Canadian stocks, U.S. or international stocks, and government or corporate bonds. If you’re including only three or four funds in your portfolio, each should be as broadly based as possible.

How does the index choose its holdings?

The most important things to understand about an ETF’s index are how it chooses the stocks or bonds it includes, and what proportion of the index each will comprise.

Traditional stock indexes select the largest and most frequently traded companies, and then weight them by their market capitalization. (You can find a company’s “market cap” by multiplying the number of outstanding shares it has by the current price of each share.) This method produces what’s called a “cap-weighted” index, where the bigger the company, the greater its influence. This is the method used by most of the indexes you’ve heard about, such as the S&P/TSX Composite or the S&P 500. iShares uses cap-weighted indexes for almost all of its equity ETFs, including its Canadian Composite Index Fund (TSX: XIC) and the Canadian S&P 500 Index Fund (TSX: XSP).

Cap-weighted indexes are the simplest to create (and the cheapest to buy), but critics point out an inherent flaw: if a stock is overvalued, it gets a bigger share of the index, while undervalued stocks get underrepresented. That makes cap-weighted indexes vulnerable to bubbles: during the 1990s, technology companies went from 5% of the cap-weighted S&P 500 to almost 30% as their stock prices ballooned, and here in Canada, Nortel alone grew until it made up more than 36% of the S&P/TSX Composite. When it turned out that tech companies were wildly overvalued, the bubble burst and ETFs tracking cap-weighted indexes were hammered.

To avoid such situations, a newer strategy called “fundamental indexing” was introduced a few years ago. In this method, companies are chosen not by their size, but according to other characteristics, such as their dividend payments, cash flow, sales and book value. The fundamentally weighted FTSE RAFI Canada Index is the benchmark for Claymore’s Canadian Fundamental Index ETF (TSX: CRQ). Using this methodology makes a big difference: the mining company Teck Resources, for example, makes up about 1.3% of a cap-weighted index, but more than 8% of Claymore’s. In general, this strategy places greater emphasis on smaller companies and those that appear to be underpriced.

Fundamental weighting has become a hot topic among ETF investors. Its proponents argue that between 1984 and 2007 using such a strategy would have added an extra 2% to returns in the U.S., and an extra 2.7% in Canada, with lower risk to boot. (If you’re interested in learning more, read The Fundamental Index, by Robert D. Arnott.) So far, that advantage has continued. Since Claymore launched three fundamental ETFs in 2006 and 2007, all of them have outperformed their cap-weighted counterparts from iShares.

Still, not everyone is convinced. “I appreciate the critique of cap-weighted indexing, but it doesn’t follow that weighting by company fundamentals is necessarily better,” says Norbert Schlenker, president of Libra Investment Management in Salt Spring Island, B.C. It’s always possible to identify a strategy that worked in the past, but there’s no guarantee it will hold up in the future, he says. “I certainly wouldn’t want people to expect an extra 2% or 3% a year by investing this way.”

There are other weighting strategies, too. BMO has an exchange-traded fund that follows the Dow Jones Industrial Average, which is weighted by price: a stock trading at $20 per share has twice as much influence as one trading at $10. Claymore offers an “equal weighted” ETF whose index tracks the financial sector by allotting 10% each to 10 banks and insurance companies.

There’s no simple answer to which methodology is best, but keep in mind that cap-weighted ETFs are almost always the cheapest, so you should pay more for a different strategy only if you are confident it will deliver higher returns

How well diversified will you be?

An ETF should give you wide exposure to the asset class you want in your portfolio. To see if it does, start by looking on the fund’s web page to see how many securities it holds.

You’ll find that the number of holdings varies a lot. For instance, if you look at the iShares Canadian Composite ETF (TSX: XIC), which is pegged to the S&P/TSX Composite Index, you’ll find it includes 204 stocks. On the other hand, the Claymore Canadian Fundamental Index (TSX: CRQ) holds only 65. But don’t be fooled into thinking that makes XIC radically more diversified. Because XIC is cap-weighted, 20 large companies make up close to 60% of the index, and all of these are included in CRQ. So even though the iShares ETF includes three times more stocks than its Claymore counterpart, most of those stocks won’t have a huge effect on performance.

Another measure of diversification is the percentage that each fund holds in the various business sectors. Here you’ll notice some significant differences: about half of CRQ is made up of banks and other financial institutions, while XIC is more heavily tilted to energy and materials. That will have a greater effect on performance than the overall number of stocks in each fund.

Does your ETF actually hold what’s in the index?

Some of the most popular ETFs in Canada track the price of natural gas, crude oil, gold and silver. If you decide to invest in one of these commodity funds, it’s important to understand how they work.

Say, for example, you want to add a gold ETF to your portfolio and you spot three possible choices: Horizons BetaPro Comex Gold (TSX: HUG), Claymore Gold Bullion Trust (TSX: CGL.UN), and iShares Canadian Gold Sector (TSX: XGD). Look further into these products and you’ll find they hold entirely different things.

Most commodity ETFs do not physically hold precious metals, oil or grains. Rather, they hold futures contracts that give them the right to purchase the commodity at a specified price on a given date. That’s how Horizons’ commodity funds work. Claymore’s Gold Bullion Trust, however, really does hold gold bullion in a vault. (Technically it’s a “closed-end investment trust,” not an ETF, but it trades the same way.) The iShares ETF, meanwhile, isn’t a commodity fund at all: it holds stocks in 28 gold-mining companies in North America.

What are the fees?

ETF management fees are generally a fraction of those charged by mutual funds. But not all ETFs are bargains.

Cap-weighted ETFs usually have the lowest fees because they are the easiest to manage. The cap-weighted iShares Canadian Large Cap 60 (TSX: XIU) charges just 0.17%, while Claymore’s CRQ holds almost all of the same stocks, but has a management expense ratio (MER) of 0.65%. Of course, if you believe that fundamental weighting can add at least half a point in returns, as it has in the past, then the higher fee is good value.

Some asset classes are inevitably more expensive than others. Small-cap ETFs, which often hold more thinly traded stocks, tend to have higher fees than those tracking large companies. ETFs holding international stocks are often pricier than those holding U.S. or Canadian equities.

ETFs that track a single sector often charge high fees despite holding few companies, and may not be worth it at all. The iShares Canadian Tech Sector (TSX: XIT) includes just five stocks, yet charges an annual fee of 0.55%. If you’re planning to invest in this sector for the long haul, you should just buy the stocks directly.

Keeping fees to a minimum is especially important in a bond ETF, where returns are usually lower to begin with. “The link between higher returns and lower expenses on bond funds, including bond ETFs, is close to perfect over the long run,” says Schlenker. “So you always want to look for a lower expense ratio.” Just make sure you compare apples to apples. For example, Claymore’s 1-5 Year Laddered Government Bond (TSX: CLF) is cheaper than the iShares Short-Term Bond (TSX: XSB), but the former holds only government bonds, while the latter also includes corporate bonds. (Claymore has a separate fund, CBO, that holds only corporates.

If you want rock-bottom fees, take a serious look at the ETFs trading on American stock exchanges. Vanguard’s Total Stock Market (NYSE: VTI), for example, charges a microscopic 0.09% and holds more than 3,300 stocks.

Does it use currency hedging?

Before you buy a U.S. equity ETF on an American exchange, though, you need to understand that you’re adding an extra layer of risk. If the U.S. dollar falls against the loonie, the value of your investment will fall with it. Canadians saw that happen in 2003 and 2004, when the U.S. stock market was on fire, but Canadians who held those stocks had their returns virtually wiped out as the loonie soared. Of course, currency fluctuations work both ways: holding stocks in U.S. dollars would have cushioned your losses during last year’s market tumble.

To reduce the effect of these swings, many Canadian ETFs that hold foreign stocks use a strategy called currency hedging. The managers use complicated financial instruments designed to smooth out currency fluctuations and deliver the full return of the underlying stocks in Canadian dollars

The problem is that hedging comes with a cost—it can add about 0.15% to 0.5% to an ETF’s expenses. What’s more, hedging is not very precise. When currency fluctuations are gradual it can work well, but if the Canadian dollar rises or falls sharply over a few weeks, investors can take a bath. That’s what happened this year to folks who owned the hedged version of the iShares S&P 500 Index Fund (TSX: XSP). Over the 12 months ending in August, the index fell about 20.5%, but XSP lost close to 27%. Two sharp rises in the loonie caught the managers off guard, and it cost investors a lot. That’s why you should think twice about paying for a feature that may backfire.

Norbert Schlenker encourages investors to consider their time horizon: over long periods, currency fluctuations tend to even out, so investors with 20 or 30 years until retirement may be better off buying a lower-cost ETF in U.S. dollars. Second, having some greenbacks in your portfolio is a good idea if you plan to travel when you retire. “Even if you expect to stay in Canada and spend all your money here, you can’t simply dismiss what might happen if the value of the Canadian dollar declines. You’ll still have exposure to things that are priced in U.S. dollars, so you should have some investments outside Canada.”

How often is the ETF traded?

The cost of an exchange-traded fund is also affected by its liquidity—that is, how often it is bought and sold.

Just like stocks, ETFs have two different prices: the “ask price” is what you’ll pay if you’re buying, while the lower “bid price” is what you’ll get if you sell. The “bid-ask spread” is the difference between the two, and the wider the gap, the greater the loss to investors on both sides of the trade. The bid-ask spread depends on two main factors: the number of outstanding shares and the average daily trading volume. You can find both of these numbers on any website that provides comprehensive stock quotes.

The Canadian large-cap ETFs from iShares and BMO offer a dramatic example. iShares’ XIU, which is the oldest and largest ETF in Canada, has more than 600 million units outstanding, and more than 12 million change hands on a typical day. Its bid-ask spread is usually just one or two cents. On the other hand, BMO’s Dow Jones Canada Titans 60 (TSX: ZCN-T), which debuted in June, has just over 200,000 units in the marketplace and often trades only a few hundred shares a day. The BMO fund’s fee is slightly less than XIU, but that difference may be outweighed by higher trading costs due to the lack of liquidity.

There’s another reason to look at trading volume: ETFs that rarely trade earn lower profits and run the risk of being shut down. A Canadian ETF should be trading at least a couple of thousand shares a day if it is to remain viable.

How closely does the ETF track its index?

Many ETFs do an outstanding job of mirroring the return of their underlying indexes. Since its debut in 2000, the U.S. version of the iShares S&P 500 Index Fund (NYSE: IVV) has strayed from its benchmark by just 0.06% annually. Unfortunately, not every ETF has such a remarkable record.

The difference between the performance of an ETF and that of its index is called the tracking error: if the index is up 8% and the ETF returns 7.2%, the tracking error would be 0.8%. You should expect an ETF to trail its index by at least as much as its management fee, but sometimes the variance is much more significant.

For example, the U.S. version of the iShares MSCI Emerging Markets Index Fund (NYSE: EEM, recently launched in Canada as ticker XEM) has posted large tracking errors over the past three years, lagging its index by 4.8% in 2007, besting it by 3.3% in 2008, and trailing again by more than 9% so far this year. Meanwhile Vanguard’s Emerging Markets ETF (NYSE: VWO) follows the same index with little tracking error. The reason is that the index includes 745 stocks, but the iShares ETF holds fewer than 400 of them. Buying 745 stocks in emerging market countries can be prohibitively expensive, so iShares selects only the largest and most influential ones. The strategy is a trade-off—increasing tracking error, but lowering costs—and over the long term it should even out. If your goal is to simply track the index as closely as possible, however, the Vanguard ETF does a better job.

Admittedly, an ETF’s tracking error isn’t always easy to determine. iShares includes a Tracking Error Chart on its website, while websites such as Google Finance and Yahoo! Finance allow you to enter an ETF’s ticker and the name of some major indexes to create a line graph comparing the two. Another useful resource is the ETF Screener on the PUR Investing website, which compares every Canadian ETF in five categories, including tracking error.

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